Downgrades: Latest bank woe

The latest alarm bell for the US banking sector has been sounded with a cut in the credit ratings of several US regional lenders and the placement of some big banks on review for possible downgrades.

Ratings agency Moody's, in an announcement late Monday, warned that US banks will find it harder to make money as interest rates and funding costs increase and a recession looms. Moody's also cited some lenders' exposure to commercial real estate as a concern.

The failures of three US lenders earlier this year precipitated the biggest industry crisis since 2008 and UBS Group's government-backed takeover of Credit Suisse. Investors remain cautious even though the upheaval has relented in recent months.

"US banks continue to contend with interest rate and asset-liability management (ALM) risks with implications for liquidity and capital, as the wind-down of unconventional monetary policy drains systemwide deposits and higher interest rates depress the value of fixed-rate assets," Moody's analysts Jill Cetina and Ana Arsov said in the accompanying research note.

"Meanwhile, many banks' Q2 results showed growing profitability pressures that will reduce their ability to generate internal capital. This comes as a mild US recession is on the horizon for early 2024 and asset quality looks set to decline from solid but unsustainable levels, with particular risks in some banks' commercial real estate (CRE) portfolios."

Moody's highlighted that the elevated CRE exposure risk is primarily attributable to the Federal Reserve's interest rate hikes, reduced demand for office buildings due to remote work trends, and a reduction in the availability of CRE credit.

The firm lowered the ratings of 10 banks by one rung, while major lenders Bank of New York Mellon, US Bancorp, State Street, Truist Financial, Cullen/Frost Bankers and Northern Trust are now under review for a potential downgrade.

Moody's also changed its outlook to negative for 11 banks, including Capital One, Citizens Financial and Fifth Third Bancorp.

Among the smaller lenders receiving an official ratings downgrade were M&T Bank, Pinnacle Financial, BOK Financial and Webster Financial.

"This (the rating downgrade) is just another reminder that there are still challenges in the regional banking space. High exposure to commercial real estate, rising deposit and funding cost are some of the key concerns that the banks are facing," said Macrae Sykes, portfolio manager at Gabelli Funds.

Wall Street reacted negatively to the ratings news but pared earlier losses in the session.

The Dow Jones Industrial Average closed down 159 points to 35,314. The Nasdaq Composite dropped 110 points to 13,884, while the S&P 500 fell 19 points to 4499.

The S&P 500 Banks index has slipped 2.5 percent year to date, compared with a 17.2 percent gain by the S&P 500, and the downgrades exposed the fragility of investors' confidence towards financial stocks. The banks index slid 1.1 percent on Tuesday, while the KBW Regional Banking index dropped 1.4 percent.

Investors have scaled back their expectations for future bank earnings, and markets have already priced in some of the factors Moody's cited, said Mike Mayo, a bank analyst at Wells Fargo.

"We are probably in the later stages of this downward revision," Mayo told Reuters. "This is the toll of higher rates for longer, the potential of a recession. It's different from what happened in the March crisis; this is more an issue about rates, recession and risk."

Kathy Jones, chief fixed income strategist at Charles Schwab, said: "As banks tighten lending standards and try to shore up their capital, there is less money flowing to the economy. Credit is the lifeblood of small and medium-sized businesses, so reducing the availability could contribute to a downturn."

The Federal Reserve's ongoing push to raise interest rates to tackle inflation "continues to have a material impact on the US banking system's funding and its economic capital", Moody's said. The Fed has raised interest rates from near zero in March 2022 to above 5 percent.

Higher rates have continued to reduce the value of bonds and other assets owned by regional banks, leaving the lenders with "sizable unrealized losses" and vulnerable to share-price drops if investors get worried, Moody's said.

"There remains a significant risk that systemwide deposits will resume their decline in coming quarters," Moody's said.

The largest banks have been relatively immune from this year's crisis. JPMorgan, Wells Fargo and Bank of America all reported higher profits in the second quarter, boosted by their ability to charge more on loans.

Investors searching for high-yielding accounts has forced some banks to pay more in interest to keep their customers. That can lead to higher costs for smaller banks that don't have the diversified income streams that big ones such as JPMorgan, Wells Fargo and Bank of America do.

"There is a recognition that unless US banks start sharing some of the wealth from higher interest rates with their depositors, they're going to see money continue to flow out," said Michael Green, chief investment strategist at Simplify Asset Management.

Chris Marinac, director of research at Janney Montgomery Scott, said second-quarter results showed the sector remains sound and that the selloff in bank stocks Tuesday was a "knee-jerk reaction" to the downgrades, The Wall Street Journal reported. "There's not fabulous profitability, but they can still make money," he said. "Moody's has now shouted an alarm bell that really isn't anything new."

Agencies contributed to this story.